The historical case for portfolio diversification into emerging market assets has long been based on the growth outperformance of emerging market countries. As these countries grew faster than their developed counterparts, reflecting either favourable demographics, large investments in human and physical capital, strong productivity gains, better governance or a mix of these, returns on invested financial capital were expected to be elevated. In turn, this justified faster growth in prices of emerging market equities. Furthermore, as income levels converged towards those of more developed economies, support for stability- oriented policies – and, consequently, lower and more stable inflation – increasingly became the norm, enabling a reduction in the risk premium embedded in these countries’ fixed income markets. Finally, stronger productivity gains called for an appreciation of emerging market currencies, at least in real terms, over the long run. For most of the past decade, empirical evidence supported this paradigm: For example, between 2002 and 2012, the Morgan Stanley Capital International (MSCI) index for emerging market equities outperformed its global counterpart by 300 per cent, while returns on local currency emerging market bonds were 40 per cent higher than those on US Treasuries over the period.
Something seems to be changing. Emerging market economic growth is still outpacing that of the developed world, but the gap is narrowing. In its October 2013 World Economic Outlook, the International Monetary Fund (IMF) projected that growth in emerging markets would slow from 4.9 per cent in 2012 to 4.5 per cent this year and pick up to 5.1 per cent next year, whereas at the same time, developed economies would accelerate from 1.2 per cent this year to 2.0 per cent in 2014. Such a narrowing, albeit a mild one, in the “growth gap” is nonetheless surprising as in the past decade or two, recoveries in the developed world generally saw the emerging economies outpace advanced economies. In a word, global recoveries used to leverage the emerging market performance, rather than undermine it.
Why is this happening? It is hard to pinpoint a single cause. But, among others, the performance of exports in many emerging economies has been poor, by historical standards, over the past eighteen months, suggesting (at least in some sectors) a loss of world market share. Also, in the current year, the co-existence of strong rates of credit growth and slowing real GDP growth in several large emerging market economies has raised concerns about a declining efficiency of invested capital. Separately, efforts by Chinese authorities to rebalance economic growth towards a more consumer-oriented model has prompted expectations that growth in China will in future be less intensive in industrial commodities, with negative implications for the major exporters of these commodities.
The big question is how much of the recent developments represent underlying structural changes, or whether some of these factors will prove cyclical – for instance, that exports will revive once the developed world’s recovery is more solidly entrenched. There are some issues that point to a structural component. Firstly, one tool through which developed economies are fostering economic improvement is by restoring competitiveness, be it via cost and price disinflation (as in the case of the euro zone’s periphery) or by allowing currency depreciation (like in Japan). Secondly, a difference between the current situation and the early 2000s – when the recovery saw emerging market growth outpace global benchmarks – is that the real effec tive exchange rates of emerging market currencies are not, on balance, as depreciated as they were at the time. Thirdly, there are increasing indications that the moderation in economic growth in the emerging world has some lasting causes, for example less favourable demographic patterns. It is significant that the IMF’s estimates for potential economic growth in all the five BRICS countries are lower, in 2013, than similar estimates made in 2011.
The likely impact of declining global liquidity
The impact of somewhat less favourable fundamentals has been compounded by concerns that the ample liquidity made available in recent years to fight the global crisis will gradually be withdrawn, perhaps in the not-too-distant future. The announcement by the US Federal Reserve in May that conditions would probably soon warrant a tapering of its asset purchase programme – which incidentally does not equate to a reduction in global liquidity, merely to a phasing down of additional injections – quickly resulted in a sharp rise in the risk premium embedded in most emerging market assets. Since Chairman Bernanke first talked about tapering on 22 May 2013, the JP Morgan index of emerging market currencies has lost 7.5 per cent of its value versus the US dollar; the Emerging Market Bond Index (EMBI) local currency index has fallen by around 2.4 per cent at the same time as the EMBI - plus sovereign spread of US dollar - denominated debt over US Treasuries increased by close to 100 basis points; and the MSCI Emerging Market equity index has fallen by 4.0 per cent, even as the MSCI World index of global equities continued to power ahead, gaining 6.0 per cent over the period.
What will happen when global central bank liquidity starts declining in earnest?
The response to tapering talk since May need not necessarily be a guide to future market moves, as the reduction in the Federal Reserve’s asset purchases is probably by now discounted to a much larger extent than it was before Chairman Bernanke spoke to Congress in May. To the extent that the Fed does not again surprise markets, but instead manages to stabilize expectations embedded in the longer part of the US yield curve, for example via the continued and effective use of its forward guidance, the impact on the global asset price constellation could be more benign than it has been so far this year. But how much is priced- in, nobody really knows.
Nonetheless, the strong correlation seen since the second quarter of 2013 between the exchange rates and bond yields of emerging countries (especially those seen as the most vulnerable to a reversal of capital inflows, because of more fragile domestic growth or external account fundamentals) and US Treasury yields, does highlight the vulnerability of the former to a further backup in the latter. Notwithstanding central bank efforts at anchoring long-term rate expectations, it seems difficult to imagine that a reduction in global liquidity – at a time when non-resident demand for US bonds, in particular, has been waning – would have no significant impact on US or core European yields. International estimates of “term premiums” embedded in longer-term bond yields did suggest that quantitative easing policies had compressed these premiums to unusually low levels; in turn, as prospects for an unwinding of quantitative easing emerged, they started to normalize. Furthermore, term premiums have shown some correlation across both developed and emerging bond markets, in particular since they began to rise from May 2013 onwards.
The case for (still) investing in emerging markets
Risks hanging over emerging market assets, however, do not mean that the case for investing in such assets is closed. First of all, while the growth out - performance of emerging countries relative to the developed world has been dwindling, this should not obscure the fact that the gap, while narrowing, remains positive, and that emerging markets remain the biggest contributors to global growth. Demographic trends, productivity gains, increases in the stock of capital remain conducive to a stronger growth performance of emerging market countries in the medium to long term. Even countries that have shown a relatively strong degree of convergence with living standards of the developed world can still out - perform the latter, as the case of Korea and Taiwan shows.
Similarly, emerging countries continue to display, on balance, better fiscal or external metrics than their developed world counterparts, whether one looks at current account balances, public deficits or ratios of public and private debt to GDP. Rather than the developments following Mr Bernanke’s comments in May 2013 representing an “emerging market crisis,” as some may want us to believe, what is probably a more correct characterization of the developments is a correction or re-pricing in the wake of expected normalization of global monetary policy and uncertainty around the speed of such normalization. What seems to further underpin the emerging markets investment case is much stronger fundamentals when compared to previous episodes of emerging markets coming under pressure, such as in the late 1990s, or even more recently in 2008. Substantial progress has been made in the last two decades towards more flexible exchange rates, reserves have been accumulated on a grand scale, fiscal positions are healthier than in many advanced economies, all of these making emerging markets overall more resilient. With regard to the more cyclical component of the recent developments, without underplaying the need for structural reform in some cases, one could even draw a more constructive conclusion of current developments, namely that depreciating exchange rates, and moderation in growth patterns may actually be testimony to how responsive these economies have become, and can adjust to changes in the underlying fundamentals.
Furthermore, global investors may at present be relatively under- weight in emerging market securities, strengthening the case for out - performance of the latter over the medium term. Private surveys of US and EU pension funds do suggest that their allocation to emerging -market debt has remained stable and relatively low, as a share of total assets under management, in recent years, even as the share of emerging market bonds in world market capitalisation continued to grow. In particular, global investor allocations to local - currency bonds of emerging market economies remain low, in part because of historical reasons of liquidity which nonetheless fade over time as emerging economies increasingly expand the size and maturity of their local bond market.
That said, not all emerging countries retain sustainably stronger fundamentals than their developed world counterparts, and growing divergences within the broad emerging market bloc, coupled with the likelihood of less abundant liquidity over the next few years, suggest that differentiation between respective emerging markets could increasingly become the norm in coming years. Whereas the immediate post- recession years had seen a strong cross-correlation between the performances of different emerging market assets, as they shared common drivers in the form of liquidity injections and interest rate expectations in the world’s major economies, such correlations have already started to wane in 2013. Country differentiation gradually began to replace the proverbial “risk on, risk off” trading patterns of the earlier period. Countries with relatively weaker growth, inflation and external account metrics saw their currency, bond and equity markets under- perform those with more solid fundamentals. Therefore, it may not be helpful to lump together countries and call them “the fragile five,” when underlying dynamics in these countries could be quite different, even if they present similarities when one looks at budget deficits and current account deficits.
Let me then finish by answering the question of whether there is still a case for investing in emerging markets with a “yes.” While challenges remain and headwinds in the form of uncertainties around Fed tapering, lower growth in key emerging market economies, and continued volatility are likely to be with us for some time, and the need to address certain structural challenges by emerging economies is beyond question, the much better fundamental backdrop of emerging markets and continued prospects of higher growth than in advanced economies, especially in regions such as Sub-Saharan Africa, appear to suggest that it would be a mistake to write off emerging markets. By rather adopting a somewhat medium to longer- term investment horizon with appropriate diversification strategies, and looking through some of the temporary turbulence, investors that maintain their loyalty to this asset class are likely to reap the benefits. Emerging markets appear to be adjusting both cyclically and structurally from spectacular levels of growth observed previously to more sustainable levels. This should continue to support a steady investment case.
By Mr Daniel Mminele,
Deputy Governor of the South African Reserve Bank. (Excerpts)
World Economic Outlook – Transitions and Tensions, International Monetary Fund, October 2013.
“Reviewing the Case for EM Local Debt – Structural Strength, Cyclical Headwind,” The Rohatyn Group, August 2013.
“Will DM’s Recovery be EM - friendly?” Emerging Market Macro Outlook and Strategy, Citi Research, 27 September 2013.